Junk Bonds Hope for a Repeat

By

Michael Aneiro

December 14, 2013

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People often look at the past year's returns to gauge next year's prospects, but rarely do the two match up. Yet bond markets are in an unusual position: Two top-performing sectors—junk bonds and leveraged loans—actually could pull off a repeat performance.

Neither has had a truly gangbusters year. Junk bonds have returned 7%, which in 2013's bond market passes for shooting the lights out, while leveraged loans—bank loans made to speculative-grade companies, which are then sold to investors—have returned 5%. By comparison, the Barclays Aggregate bond index, a broader benchmark focused on higher-rated debt like Treasuries, has lost 1.9%. The S&P 500 stock index is up 24.5%.

Bond investors need to get used to modest expectations, even for sectors that once offered more upside. A three-decade tailwind of falling interest rates and rising bond prices reversed in 2013. Paradoxically, bonds historically regarded as higher-risk—as defined by credit risk, which over the past 30 years has been the dominant risk for bonds—have been less susceptible to interest-rate risk, the most prevalent risk of 2013, which measures how rising rates erode the price of existing bonds.

Junk bonds have been buffered by higher yields and thicker cushions, or spreads, over comparable Treasury yields. Loans are further protected because their rates can float. As for credit risk, the default rate among junk-rated companies is just 2.4%, as even the riskiest companies have been able to refinance debt in recent years.

Alas, any repeat performance probably means an even more muted version of 2013's gains. Take junk bonds, which entered 2013 yielding 6.09% on average, 5.31 percentage points more than comparable Treasury yields, and trading at 104.35 cents on the dollar. Now they yield 5.64%, at a spread of 4.11 percentage points and a price of 103.4 cents.

So year-to-date gains come mostly from coupon income, plus a bit of spread compression. This is significant because the historically volatile junk-bond market rarely experiences such a so-called coupon-clipping year, in which year-end returns pretty closely align with yields at the start of the year. In fact it's so rare that—barring a crazy end to December (I'm looking at you, Federal Reserve)—this will mark the first time in 23 years that the Barclays high-yield index returns between 6% and 10% in a calendar year.

After such a drought, could we see two coupon-clipping years in a row? Rates aren't expected to rise sharply next year, nor are defaults. The biggest risk is that some unforeseen crisis spooks markets. In May and June, when rates surged, corporate-bond spreads—which should have fallen, acting like shock absorbers—rose, surprising nearly everyone and showing how markets can defy expectations when in crisis mode. Eventually speculative-grade debt rebounded to have what looks, by year-end results, like an uneventful year.

As for loans, investors have flocked to them because of their floating rates, but loans are tied to short-term rates, which haven't moved much. Loans are senior to junk bonds and offer only a bit less yield, but like any overbought asset class they look rich.

Credit risk will return with a vengeance eventually—junk-bond guru Martin Fridson recently predicted a $1.5 trillion wave of defaults beginning in 2016. Until then, junk-rated debt provided some uncharacteristically dependable, if unusually low, yield in 2013, and could do so again in 2014.

THE TREASURY MARKET sat on its hands ahead of the Federal Reserve's final policy committee meeting of 2013, which starts Tuesday. Recent data suggest a strong enough economy for the Fed to start tapering its $85 billion monthly bond purchases, but most pundits expect it to wait until Ben Bernanke's term expires next month. The 10-year Treasury note yielded 2.86% Friday, unchanged from a week before.

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